Managing Commodity Lifecycles, Petroleum

2. Why petroleum markets are cyclical

Four major oil price cycles occurred in the last four decades as summarized in the below Table, roughly one cycle per decade. Each time the price dropped in the range of 60-75 percent during the bust period of each cycle. Thus, the fall in oil price was 75 percent between June 2014 and January 2016, a level of drop similar to the variation observed in 2008-09 or in 1986. Each time, the rapid fall and its extend were unexpected by the majority of the specialized publications dealing with oil price forecasts and the futures markets, showing the major difficulty for price and revenue forecasting even on a short- to medium-term basis.

In this RAW Talks video, Paul Stevens explains how is the price of oil determined?

The reasons for petroleum price cycles lie in the volatility of world oil demand and the low responsiveness of global oil supply, creating either an oversupply of the markets leading to a rapid fall in price up to building again a balanced market, or the contrary in case of oil undersupply.

Demand for petroleum is highly sensitive to changes in the rate of economic growth. This is because faster economic growth brings with it increased petroleum demand for transportation and industrial usage, while rising incomes also boost domestic demand. The relationship between year-to-year changes in global oil consumption and in global GDP is shown in the figure to the right.

Supply of mineral commodities is typically inflexible and producers find it hard to respond to fluctuations in demand. This inflexibility arises from the fact that mineral commodities are commonly produced at large-scale, capital-intensive operations. For reasons of cost-effectiveness, producers like to run their operations at close to full capacity. Even in the face of weakening demand and prices, the internal economics of their operations may result in producers continuing to produce flat out, weakening prices further.

The capital-intensive nature of mineral production explains another facet of supply inflexibility – the difficulty in expanding production once all the existing capacity is used up. Large, capital-intensive projects take a long time to develop, finance and construct. It is common for a major new mine to take ten years from conception to production. Accordingly, supply is often slow to respond to surges in the demand for mineral commodities and associated shortages.

Prices are the mechanism by which the demand and supply of commodities are brought into balance. When markets are oversupplied and prices are low, producers are forced to cut costs. When they can no longer produce minerals economically, operations are sold or closed.

When markets are undersupplied and consumers are experiencing shortages, prices rise. This helps ration the available supply to consumers in line with their ability to pay. It also provides an incentive to producers to squeeze out as much production from their existing plants as they can and to invest in new production capacity. However, supply adjustments, both in cyclical downswings and upswings, can be slow and take several years to complete. It may not be an exaggeration to say that the normal condition of commodity markets is imbalance, with prices most of the time either trending cyclically upwards or downwards.

In this RAW Talks video, Paul Stevens explains wheter prices will rebound as we move away from oil.